How Long Do I Have to Hold a Rental Property Before I Can Move into It?

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Tina, you’ve got a question for me from what I understand.

Tina Colson: I do. I own a lot of investment properties, and I keep thinking into the future and downsizing someday. I’m just wondering, David, is there a way that I can take that investment property that I identify and make it my personal residence one day? How would I go about doing that?

David Moore: Sure. I think you’ve got to look at a couple of different things. People look at a primary residence. We were talking about Section 121 a bit ago, exclusion and what qualifies, and you start looking at how you define a primary residence. How do you define property held for investment? As far as hold periods and everything else, people always want to put a black and white timeline on there.

A lot of times people say, “Well, your question is in effect about converting an asset, but really the question is what do we have to do to satisfy 1031’s intent and how do you do that?” If we look at 1031, I think one of the big misunderstandings or misconceptions out there is a lot of times people say 1031 contains a two year required hole, which is absolutely untrue.

David Moore: If you and I were brother and sister, yes. There’s a two year required hold in a related party Exchange, but even in that situation, it’s not an absolute. If we can show that there was no intent to avoid tax- forgetting for the moment that maybe that 1031 could be considered in an effort to defer- we’re going to say not avoid, but to defer tax and deferred gain. Even in a related party transaction, it says two years or if you can prove there’s no intent to avoid tax, and that doesn’t even apply in that situation.

If we look at just an arms length transaction, how long does something have to be held? I typically tell people a year based upon a couple of different factors. One, if it’s been proposed a couple of times. Two, where’s the break between short and long-term tax rates on assets held for investment?

David Moore: With that said, there’s actually court cases where properties or Exchanges were successfully defended after even a shorter period of times as four months. That court case sort of dovetails into your initial question, which for those of you that might’ve forgotten by now with all my babbling, really was, “Could I Exchange a no property and convert it into a primary residence or a second home?”

The answer is certainly yes. How long should give wait? That’s really up to you and your tax counsel. They might say two based upon what we just described. I would say different tax years would be great … At least a year. Once again, I’m going to say the year based upon those factors I’ve previously mentioned. Yes, it’s certainly possible to Exchange out of a property that’s been held exclusively as investment, and acquire a property with the intent to hold for investment and ultimately convert it to a primary residence.

David Moore: I have no qualms saying that, because the IRS has actually given us rules on that. They put things in place, so if we go back in the 90s we’d have somebody Exchange out of a property … Maybe they have a subdivision, they build a house, and they live in that thing.

You think they could Exchange into that thing, break it all up, build a house, live in it for two years, sell it, move in the next one, live in two years, sell it, take the exclusion and boom, boom, boom, boom, boom … Builder developers do that all the time, right? If we look at 1031, we’ve got a situation where the government saw this happening and they saw people buying a property via 1031, and holding it for let’s say a year, moving into it, living it for two, dumping it, taking the exclusion, and getting rid of all the gain. Do you think the government would like that?

Tina Colson: No. Absolutely not.

David Moore: Absolutely not, she says. Correct. They put a five year minimum hold in place, and that’s slowed things down basically, but you’ve got to understand any time they put a rule in place … What the downside is we now have a timeline that we have to play with, but what’s the positive of it?

They’ve acknowledged you can do it, so we don’t have worry about whether you can or can’t do it. They said, “Hey, this is how.” Now, the five-year hold- What that meant is if you Exchange into a property and held it for, let’s say, a year or so or whatever you and your tax people decide on, you move into it and you live in it for two. Let’s say we’re three years into it now, and if you were to sell it after three years, even though you’re qualified for the universal exclusion, that Section 121 at that time, the government’s going to say, “No. It’s a fully taxable sale.”

David Moore: If you buy something via 1031 converted, sell it inside five years of total hold, it’s going to be a fully taxable sale. If you hold it for longer than that, like I said, the government didn’t see that stopping it enough, so we had the Housing Assistance Tax Act that came in 2007 or 2008, and it became effective April of ’09.

That thing says you have to hold a property for no less than five years, and then after that you can apply both section 1031 and 121, or 1031 was applied getting into it and 121 on sale. But it’s only going to give you a proration of the 250 or 500, and the proration is based upon the qualified versus non-qualified use periods from that effective date. You’ve got to look at things, and you will never fully have the entire 250 or 500 using an Exchange into a property.

David Moore: I tell people, “Forget it if you just want to get rid of the gain. Don’t look at. It’s not going to be effective for you. If it’s a place for you to get into for your retirement or ultimately to move in and retire into and live in, it’s a very effective tool like it’s always been, but don’t look at it as a way to just do this transaction and then sell it after a few years. It doesn’t work any longer.

It’s a tremendous opportunity with restrictions, but with the rules comes clarity on the process. Yes, you can do it. Just slow it down and look at it as a place to be, and not a place to just go and hide the taxes after a couple of years.

Tina Colson: Great. Thank you so much for answering that question.

David Moore: Sure.

Tina Colson: I know that we’ve got a lot of clients who ask that question as well. However we can serve them best, that’s what we’re after.

David Moore: Great. Great. Great. David Moore with Tina Colson, Equity Advantage, 1031Exchange.com. Thank you.

Tina Colson: Thank you.